February 27, 2002

In the past twelve months, consumer prices have advanced by the smallest amount since 1986.  Many Wall Street analysts aver that inflation is dead.  Yet, within three years of 1986, prices were again growing more than 4 percent per year.   This time, is inflation buried, or is the good results the result of temporary conditions?

On the surface, the future looks good for price stability.  In the past three months, consumer prices showed no gains at all.  Furthermore, the sensitive prices in the producer price index fell again.  However, the decline in sensitive prices is slowing while energy accounted for much of the recent price weakness. 

A more cautionary tale can be read in prices excluding food and energy.  Those gains in the past year and in the past three months have been 2.6 percent.  This means that when energy prices stabilize, and they may already be trying to do that, inflation will jump.  Also, even with a 25 percent decline in energy prices, a recession, and rising unemployment, core prices have not moderated. 

Indeed, the 2.6 percent price gains are almost half a percentage point higher than core inflation just a couple years ago. 

In short, the right question is not why inflation is so low:  unsustainably high energy prices a year ago have come down.  Rather, why has core inflation remained so resistant to economic weakness. 

Some of the answer is in decreased price sensitivity to economic conditions for some goods and services.  For example, the fastest price gains in the past year  are in hospital fees, school tuition, and tobacco products.  Despite economic weakness, a shortage of trained hospital personnel in an industry growing 4 percent per year even in recession explains some of those medical price pressures. 

Those legal settlements with states by the tobacco industry are still being paid by tobacco product users, although those price gains are diminishing.  College demand tends to rise when jobs are scarce.  There is little cost of lost wages in upgrading skills during weak economic times. 

Price weakness has actually intensified in clothing, vehicles (both new and used) and lodging.  That record sale of new cars during the fall has created a huge supply of recently owned cars.  Used car prices may be trending downward a few more months.  Whether the new car producers can continue to pressure their suppliers for ever lower prices remains to be seen.

Of course, the plunge in travel led to price concessions that still are holding down the costs of lodging.  Some business conventions are occupying upscale hotels at rents that are lower than the moderate priced facilities down the street.  When business begins to travel again, probably later this year, this will end. 

Probably the most unusual weakness in pricing is in clothing.  In the past year, clothing prices have declined 4 percent.  They fell at an annual rate of 7.7 percent in the past three months.  Some of this was to entice reluctant consumers to take goods off the racks at Christmas.  Merchants did not want to left with unwanted inventories after Christmas for a second consecutive year. 

However, the price concessions were most intense for women's garments and least aggressive for children's and infant's clothing.  The vast majority of our women's wear other than fashion is being produced abroad.  Most of the infant and children's clothing is not.  In other words, one can sense international pricing pressures caused by a strong dollar in clothing pricing. 

If so, clothing prices are becoming more sensitive to the dollar's value.  Lat year, the dollar rose slightly more than 5 percent in value against the average currency as measured by the volume of trade done with the U.S. Not surprisingly, the price concessions for women's clothing were just over 5 percent. 

This assumption will be tested when the dollar begins to fall in value.  Will clothing prices continue to plunge if the dollar begins to fall?  My guess is that clothing prices will rise with a weak dollar.  However, we have not seen such an event in more than 4 years. 

Having told you more than you wish to know about domestic prices, what do I see ahead for inflation. 

I am sensing that the euro will slowly gather strength.  My worry is a series of competitive devaluations to thwart Japan's attempt to eliminate deflation by devaluing its dollar. Indeed, that possibility is my biggest economic worry for the new year. 

Still, the dollar probably will give some ground.  Therefore, the plunge in clothing prices will end and some increase is likely. 

Auto prices will remain weak this year but probably will not weaken further as new vehicle prices firm and used car prices remain soft.  The economically insensitive pricing of hospital fees, tobacco products, and school tuitions will remain economically insensitive. 

Lodging prices will firm later in the year.  The plunge in computer prices also will diminish (they rose two of the past three months at the producers' level).  While the important housing sector could continue to see price moderation, I believe core inflation will be closer to 3 percent than to 2.5 percent at the end of this year. 

Food inflation should be close to core inflation, as it was this year.  Some moderation in prices for vegetables and proteins (meat and dairy) will be offset by higher prices for grain and fruit related products.

Finally energy deflation will vanish.  No great rebound is expected in prices, but energy prices in January were restrained by falling electricity prices.  In the chain of energy pricing, electricity is at the end.  They show price declines well after the pressure has turned. 

I do not think that energy prices will rise much.  Too much capacity is shut in for that to happen.  However, 25 percent declines will not recur. 

Therefore, that 1.1 percent CPI gain in the past twelve months will be replaced by one that is closer to 3 percent in the next twelve months.  If this is dead inflation, show me a picture of when it is live. 



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